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Stock Options and the Smaller Business

by | Mar 7, 2016 | All Blog Entries, Employee Compensation, ESOP

Stock options and stock ownership plans are a popular and effective method of incentivizing employees, often at a low cost to both the employer and the employee. Several types exist, including non-qualified stock options, incentive stock options, employee stock ownership plans, phantom stock, stock appreciation rights and more. In this second of a series of articles, we will look at Phantom Stock Options and Stock Appreciation Rights.

Phantom Stock Options and Stock Appreciation Rights

Under traditional stock option plans, an employee can become an owner of the company. Often, a business owner does not wish to pass along ownership. But s/he does want to incentivize key employees. Phantom stock options (“mirror stock” or “shadow stock”) and stock appreciation rights (SARs) both provide these features.

As with other stock plans, a set of milestones can be established. The “shares” are “issued” when the milestone is reached.

Phantom stock plans are tied to long-term company performance. There are advantages to both the employer and employee traditional stock plans don’t offer. Employees do not need to invest any money. Nor are they subject to corporate governance issues that may arise. They cannot be asked to personally guarantee company obligations. Most importantly, if they wish to sell shares under a traditional plan, their options may be limited. Typical smaller businesses are not traded and often do not hold any defined means for redeeming shares. This issue is not relevant for a phantom plan.

For an employer, the shares are “phantom”, the employee is NOT an owner. These employees hold no authoritative input in the management of the business. Yet, the employee can be incentivized through additional value added to the business, much like an owner. Administratively, these plans are much less complex than traditional stock option plans.

For the employer and the employee, the exercise of the option becomes an immediate taxable event. The employee reports it as ordinary income; the employer as a deduction.

With a SAR, many of the same advantages exist as with phantom stock. The key differences are in the exercise of the option and the amount of the award. A SAR can be exercised at the employee’s discretion once the vesting schedule is met. A phantom plan calls for exercise at the time the vesting schedule is met. A SAR awards the employee the amount equal to the difference between the FMV of the underlying stock at the exercise date and the grant date. The recipient of phantom options receives the full value of the share.

An attorney and a tax advisor should design the plan with your guidance to avoid any legal or tax consequences.

At JBV, we have valued many stock option plans, from ESOPs to phantom stock and SAR plans to ISOs and more. We are here to assist you.

What Is Fair Market Value? The IRS v The Taxpayer

by | Nov 20, 2015 | All Blog Entries, Corporate, ESOP, Succession Planning

James and Julie Kress (the “Taxpayers”) filed a lawsuit in United States District Court for the Eastern District of Wisconsin [Case 1:15-cv-01067-WCG] on September 2, 2015. They sought a refund of federal gift taxes and interest they claim were erroneously assessed by the IRS on gifts made in 2007, 2008, and 2009.

The Facts

The Taxpayers are shareholders of an S corporation. The shares are owned by members of the Taxpayers’ family and certain employees and directors. The company’s bylaws and shareholders’ agreement restrict transfer of shares by family members to other family members or to trusts, as defined in the bylaws. An annual valuation opines the value of minority blocks of the shares.

The bylaws and shareholders’ agreement also stipulate transfers of stock by non-family shareholders are subject to a right of first refusal by the company. The bylaws and stockholder agreements specify these transfers must be at 120% of the company’s book value at the time of transfer.

In the years stated above, minority shares were gifted to members of the Taxpayers’ family at Fair Market Value as determined by an independent valuation. These valuations took into account the restrictions on transfers of shares held by family members.

The IRS challenged these amounts. It determined the gifts should have been valued at 120% of book value, the value which the company’s shareholders agreement and by-laws provide for transfers by non-family members.

The Issue

Fair Market Value is defined as the value a property would receive if it were sold in the open market. Among other factors, it assumes the buyer and seller are reasonably knowledgeable about the property in question, they are acting in their own best interest and neither party is under any undue influence.

In this Case, we see two sets of values. One is the values determined by the independent valuations, the other is 120% of book value. The Taxpayers assert the transfer price calculation for non-family members is to simplify transfers. (Shares transferred by non-family members typically had different, and much higher, bases than those transferred between family members).

The Taxpayers claim the restrictions on family transfers are a “bona fide business arrangement.” The restrictions, they claim, were not designed to attain discounted values.

So who is right?

The Taxpayers believe an independent valuation of their company should address the stock restrictions unique to family-owned shares. Because of these restrictions, the value of the shares is heavily discounted. The family contends the restrictions are intended to centralize ownership of the company in the family, not to lower the fair market value of transferred shares.

The IRS has been and is continuing to scrutinize transfers of stock among family members, especially those with high discounts. A perceived goal of the IRS is to prevent businesses from reducing the value of their shares through the imposition of severe restrictions limiting transferability of shares by family members. The IRS claims its valuation at 120% of book value better reflects what an external party would expect to pay for shares. It should be noted employees and directors are not third parties.

This case remains pending.

DOL Proposes New Definition for Fiduciary

by | Jul 27, 2015 | All Blog Entries, ESOP, Succession Planning

Since 1975 and prior to April 2015, the definition of fiduciary as put forth by the Department of Labor included a five-part test. Only if all five parts listed below were met would an adviser be considered a fiduciary. Advice was given:

  • as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing or selling securities or other property;
    on a regular basis;
  • pursuant to a mutual agreement, arrangement or understanding, with the plan or a plan fiduciary;
  • that will serve as a primary basis for investment decisions with respect to plan assets; and
  • that will be individualized based on the particular needs of the plan or IRA.

In the April 2015 proposed rule, the definition of fiduciary is expanded. If a person meets this definition below, s/he is considered a fiduciary:

  • provides investment or investment management recommendations or appraisals to an employee benefit plan, a plan fiduciary, participant or beneficiary, or an IRA owner or fiduciary, including advice regarding rollovers and distributions from ERISA plans and IRAs;
  • for a fee or other direct or indirect compensation; and
  • either (a) acknowledges the fiduciary nature of the advice, or (b) acts pursuant to an agreement, arrangement, or understanding with the advice recipient that the advice is individualized to, or specifically directed to, the recipient for consideration in making investment or management decisions regarding plan assets.

Exceptions, or carve-outs, are provided:

  • statements or recommendations made to a “large plan investor with financial expertise” by a counterparty acting in an arm’s length transaction;
  • offers or recommendations to plan fiduciaries of ERISA plans to enter into a swap or security-based swap that is regulated under the Securities Exchange Act or the Commodity Exchange Act;
  • statements or recommendations provided to a plan fiduciary of an ERISA plan by an employee of the plan sponsor if the employee receives no fee beyond his or her normal compensation;
  • marketing or making available a platform of investment alternatives to be selected by a plan fiduciary for an ERISA participant-directed individual account plan;
  • the identification of investment alternatives that meet objective criteria specified by a plan fiduciary of an ERISA plan or the provision of objective financial data to such fiduciary;
  • the provision of an appraisal, fairness opinion or a statement of value to an ESOP regarding employer securities, to a collective investment vehicle holding plan assets, or to a plan for meeting reporting and disclosure requirements; and
  • information and materials that constitute “investment education” or “retirement education.”

A comment period expired in June with an expected final hearing date in late July 2015.

The DOL specifically carves out valuation analysts from the role of a fiduciary. At JBVal, we always consider it our mission of providing a defensible valuation that is fair to all to include all participants in the ESOP, as well as its Trustees and the company that sponsors it.

IRS May Try to Restrict Discounts

by | Jul 27, 2015 | All Blog Entries, Corporate, Employee Compensation, ESOP, Succession Planning

At the American Bar Association (ABA) Section of Taxation meeting on May 8th, 2015, Catherine Hughes, of the Office of Tax Policy in the U.S. Treasury Department, announced that proposed regulations under section 2704(b)(4) could be released before the fall. She indicated that the tax community could look to the Obama Administration’s prior budget proposals on valuation discounts for clues about what the proposed regulations might provide.

Section 2704(b)(4) states:

The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if the such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.

Many believe the IRS does not have the authority to ignore minority and marketability discounts without Congressional action.

The IRS has unsuccessfully tried the Congressional route before.

A proposal was included in President Obama’s budget proposals in each of fiscal years 2010 to 2013. These proposals called for the elimination of discounts in family-controlled entities. None made it to the final approved budget.

Within the last ten years, the Certain Estate Tax Relief Act of 2009 appears to be the sole introduced bill on the topic. (Note my search was unscientific and may exclude other recent actions.)

HR 436: “Certain Estate Tax Relief Act of 2009”

This bill proposed the elimination of the ability to apply discounts for lack of marketability for transfers of “nonbusiness assets” of an entity. “Non-business assets” are those that are “not used in the active conduct of one or more trades or businesses.” For example, the new law would disallow a lack of marketability discount for the transfer of an interest in an entity that relates to the entity’s holdings of marketable securities.

Exceptions would have applied to two particular types of assets. First, an exception would have been made for real property owned by an entity is which the transferor materially participates, which would be measured in a manner similarly to passive activity limitations for income tax purposes. Second, an exception would have existed for “reasonably required” working capital of a trade or business.

Additionally, the Bill disallowed any minority discount for transfers of interests in a family controlled entity. This would have attributed ownership of the transferor to their spouses, parents, children, grandchildren, etc., thus eliminating the minority interest discount.

Status – Died in Congress

Does this mean the current attempt will fail? Who knows! However, panic mode is not called for.

DOL v PBI Banks, Inc. and The Miller’s Health Systems, Inc. Employee Stock Ownership Plan

by | Jun 10, 2015 | All Blog Entries, ESOP, Succession Planning

No case is clear cut, but lessons often can be learned.  In the recently filed action, the Department of Labor v PBI Bank, Inc. and The Miller’s Health Systems, Inc. Employee Stock Ownership Plan (United States District Court for the Northern District of Indiana, Civil Action: 3:13CV1400), some, but not all, of the issues surrounded the valuation report.

In this initial ESOP transaction, multiple drafts of a valuation report were produced.  The ultimate valuation, according to the Department of Labor’s filing, failed to consider several items.

  • No marketability discount was applied.  Though drafts of the report included a discount of 5%, the final version had none.
  • The stock purchase agreement included an earn-out agreement which provided the selling shareholders an amount equal to 40% of future earnings over a specified threshold for about eight years.  The valuation, according to the Department of Labor, failed to address this issue.
  • A stock option plan set aside 20% of Company shares for the selling shareholders, at a strike price of $4.08 per share.  The valuation for the initial transaction provided a total value of $42,379,000 for the 1,000,000 outstanding shares, according to the Department of Labor.  At the valuation date, these options apparently were “in the money” but according to the Department of Labor, the dilutive effect was not considered in the final report

Note that all of the above statements are based on our interpretation of the Department of Labor’s filing, not on a final Court decision.

Other issues outside the valuation report trumped those mentioned above.

The ‘lesson learned’ here is to ensure the valuation analyst knows the intricacies of an ESOP, particularly with the initial valuation.  At our firm, we review all important company resolutions and agreements, those directly associated with the ESOP and those created contemporaneously with the ESOP transaction.  We look at the financing arrangements.  We discuss all of items these with the Plan Administrator, the Trustee and company management.

We don’t opine unless we’re satisfied the final opinion is reasonable, fair to all parties, and, most importantly, can be supported. A DOL auditor recently remarked to a client our work product was among the most thoroughly documented he had reviewed.

ESOP Fiduciaries 2013

by | May 3, 2014 | All Blog Entries, ESOP, Succession Planning

Early in 2013, the Supreme Court asked the Solicitor General to comment on technical questions regarding stock-drop cases and to assess whether these types of cases should be brought to the attention of the Court. In a rather strange move, the Solicitor General asked the Court to focus only on a matter concerning ESOP plan fiduciaries, and whether they are entitled to the presumption that they have acted in the best interests of plan participants by investing in company stock.

“Congress, and former Presidents, has consistently encouraged ESOPs for over 30 years,” said ESOP Association President, J. Michael Keeling. “The presumption that ESOP plan fiduciaries act prudently when company stock is the ESOP’s primary asset was decided by the Third Circuit in Moench V. Robertson,  a 1995 case that plaintiffs won, making it clear bad actors do not prevail but also acknowledging Congress has endorsed ESOPs and Presidents have signed pro-ESOP laws. This pro-ESOP Moench position has been upheld by a majority of Federal courts for years, and one can only presume from the Solicitor General’s question of Moench that the Justice Department is looking to harm ESOPs.”

There is concern that if the Supreme Court agrees with the Administration, there will be a rise in lawsuits challenging ESOP companies. Numerous anti-ESOP lawsuits would do harm to ESOP companies and their employee owners.

“Since 2010, the ESOP community has been fighting a proposed regulation from the Department of Labor regarding the definition of an ESOP fiduciary. The Solicitor General’s attack on ESOPs is one more dig from an Administration that has demonstrated negative views of employee ownership as evidenced by its budget proposal justifying the reversal of a pro-ESOP tax law because, according to the Administration, employees working for companies with more than 10 – 15 employees are incapable of understanding how their actions impact their company. It’s counter-intuitive to hear the Administration preach about creating jobs and then try to take away a proven policy that sustains jobs,” stated Mr. Keeling.